CERTIFIED ACCOUNTING TECHNICIAN

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1 CERTIFIED ACCOUNTING TECHNICIAN Paper FAU Foundations in Audit STUDY TEXT

2 PAPER FAU : FOUNDATIONS IN AUDIT British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Published by: Kaplan Publishing UK Unit 2 The Business Centre Molly Millar s Lane Wokingham Berkshire RG41 2QZ ISBN: Kaplan Financial Limited, 2017 Printed and bound in Great Britain Acknowledgments We are grateful to the Association of Chartered Certified Accountants for permission to reproduce past examination questions. The answers have been prepared by Kaplan Publishing. This Product includes content from the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for Accountants (IESBA), published by the International Federation of Accountants (IFAC) in 2015 and is used with permission of IFAC. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Kaplan Publishing. The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. P.2 KAPLAN PUBLISHING

3 CONTENTS Page Introduction P.5 Syllabus and study guide P.7 The examination P.11 Study skills and revision guidance P.13 Chapter 1 Auditing and the audit profession 1 2 Professional ethics 13 3 Statutory audits 21 4 Auditing concepts: true and fair, materiality 31 5 Audit risk and planning 41 6 Internal controls 75 7 The audit evidence process: tests of control Sampling Audit verification work 1 General principles Audit verification work 2 Inventory Audit verification work 3 Non-current assets Audit verification work 4 Receivables and cash and bank Audit verification work 5 Liabilities Computers in audit The final review stage The audit report The auditor's liability 297 Answers to activities and questions 309 Index 383 Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an to mykaplanreporting@kaplan.com with full details. Our Quality Coordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. KAPLAN PUBLISHING P.3

4 PAPER FAU: FOUNDATIONS IN AUDIT. P.4 KAPLAN PUBLISHING

5 INTRODUCTION This is the new edition of the FIA study text for Foundations in Audit, approved by the ACCA and fully updated and revised according to the examiner s comments. Tailored to fully cover the syllabus, this Study Text has been written specifically for FIA students. Clear and comprehensive style, numerous examples and highlighted key terms help you to acquire the information easily. Plenty of activities and self-test questions enable you to practise what you have learnt. At the end of most of the chapters you will find practice questions. These are exam-style questions and will give you a very good idea of the way you will be tested. A full review by the ACCA has ensured that this book fully reflects what could be tested in the exam. KAPLAN PUBLISHING P.5

6 PAPER FAU: FOUNDATIONS IN AUDIT P.6 KAPLAN PUBLISHING

7 SYLLABUS AND STUDY GUIDE Position of the paper in the overall syllabus The FAU paper requires knowledge and understanding of FAB (Accountant in Business), FMA (Management Accounting) and FFA (Financial Accounting). Syllabus A Business environment and audit framework Chapters 1, 2, 3, 4, 17 (a) The purpose and scope of an audit (b) The legal duties of auditors (c) Professional ethics (d) Auditor engagement and liability (e) Audit regulation B Audit planning and risk Chapter 5 (a) Audit risk and risk assessment (b) Understanding the entity and its environment (c) Audit strategy and audit plan (d) Audit documentation C Internal control Chapters 6, 7 (a) General principles of internal control (b) Techniques to record and evaluate accounting systems (c) Tests of controls (d) Communicating control deficiencies D Audit evidence and procedures Chapters 8 14 (a) Audit evidence (b) Audit procedures (c) Substantive procedures (d) Audit sampling (e) Computer-assisted audit techniques (CAATs) E Audit completion Chapters 15, 16 (a) Going concern (b) Subsequent events (c) Written representations (d) Recording significant and material errors (e) Auditor s reports Excluded topics The following topics are specifically excluded from the syllabus: group audits detailed understanding of audit requirements relating to: fraud auditing standards on laws and regulations related parties service organisations Key areas of the syllabus The key topic areas are as follows: controls audit planning practical application of audit techniques preparing draft reports. KAPLAN PUBLISHING P.7

8 PAPER FAU : FOUNDATIONS IN AUDIT Study Guide A BUSINESS ENVIRONMENT AND AUDIT FRAMEWORK 1. The purpose and scope of an audit (a) Explain the nature of an audit. (b) Explain the purpose of an audit, including the advantages and disadvantages of an audit. (c) Explain the nature of accounting records, including proper records. (d) Explain the concept of true and fair presentation, and reasonable assurance. (e) Identify the content of the auditors report. 2. The legal duties of auditors (a) Explain the regulations governing the appointment, removal and resignation of auditors. (b) Describe the duties of auditors. (c) Describe the rights of auditors. 3. Professional ethics (a) Discuss the fundamental principles of professional ethics of integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour (b) Describe the detailed requirements, and application of professional ethics, in the context of integrity, objectivity and independence (c) Describe the auditor s responsibility with regard to confidentiality 4. The liability of auditors (a) Explain the factors that auditors should consider before accepting an audit engagement (b) Explain the purpose and nature of an engagement letter (c) Explain the liability of auditors under contract and negligence to clients. (d) Explain the liability of auditors to third parties. 5. Audit regulation (a) Explain the structure of the auditing profession. (b) Explain the scope of ISAs. B AUDIT PLANNING AND RISK 1. Audit risk and risk assessment (a) Define audit risk, including inherent risk, control risk and detection risk. (b) Explain a risk-based approach to the audit (c) Define the concept of materiality. 2. Understanding the entity and its environment (a) Explain how auditors obtain an initial understanding of the entity and its environment. 3. Audit strategy and the audit plan (a) Identify and explain the need for planning an audit. (b) Identify and describe the contents of the overall audit strategy and the audit plan. (c) Explain the use of analytical procedures in planning. (d) Describe planning issues such as staffing. (e) Explain the role of audit programmes and the advantages and disadvantages of using standard audit programmes. 4. Audit documentation (a) Describe the reasons for maintaining audit documentation. (b) Explain the purpose and contents of the current file and the permanent file. (c) Explain the quality control procedures that should exist over the review of audit working papers. (d) Explain how information technology (IT) may be used in the documentation of audit work. C INTERNAL CONTROL 1. General principles of internal control (a) Describe the five components of an internal control system. (b) Describe the objectives of an internal control system. (c) Describe the inherent limitations of an internal control system. (d) Explain the importance of internal control to auditors. P.8 KAPLAN PUBLISHING

9 SYLLABUS AND STUDY GUIDE 2. Techniques to record and evaluate accounting systems (a) Describe the techniques used by auditors to understand, record accounting systems including narrative notes and flowcharts. (b) Describe the techniques used by auditors to evaluate accounting systems including internal control questionnaires (ICQs), internal control evaluation questionnaires (ICEQs) and checklists. (c) Provide examples of, and explain the format and contents, ICQs and ICEQs. (d) Evaluate the internal control system. 3. Tests of controls (a) Describe and illustrate control procedures to meet specified objectives for each of the following areas purchases and trade payables sales and trade receivables wages and salaries (payroll) tangible non-current assets inventory bank receipts and payments cash receipts and payments. (b) Explain the purpose of tests of controls. (c) Explain the testing of controls over the following areas: purchases and trade payables sales and trade receivables wages and salaries (payroll) tangible non-current assets inventory bank receipts and payments cash receipts and payments. (d) Distinguish between tests of controls and substantive procedures. (e) Distinguish between application controls and general IT controls and identify the objectives of each control type. (f) Provide examples of specific application controls and general IT controls. (g) State the typical control problems encountered in small computer-based systems. 4. Communicating control deficiencies (a) Identify and define significant internal control; deficiencies and explain the requirements and methods for communicating significant deficiencies to management and those charged with governance. D AUDIT EVIDENCE AND PROCEDURES 1. Audit evidence (a) Explain the importance of audit evidence, including sufficient appropriate audit evidence. (b) Identify the factors that influence the relevance and reliability of audit evidence. 2. Audit procedures (a) Explain the importance of the use of the assertions. (b) Explain the assertions in relation to classes of transactions (c) Describe the procedures used by auditors to obtain audit evidence, including inspection, observation, external confirmation, recalculation, reperformance, analytical procedures and inquiry 3. Substantive procedures (a) Explain the rationale for designing audit programmes by reference to audit objectives. (b) Explain the substantive procedures used in auditing each of the following: tangible non-current assets investments trade receivables, prepayments and other receivables trade payables, accruals and other payables bank and cash non-current liabilities provisions. (c) Explain why the audit of inventory is often an area of high inherent risk. (d) Describe the audit procedures that should be undertaken before, during and after attending an inventory count. KAPLAN PUBLISHING P.9

10 PAPER FAU : FOUNDATIONS IN AUDIT (e) Describe the extent to which an auditor may rely on a system of perpetual inventory. (f) Explain the substantive procedures to meet the specific objectives for the audit of inventory. 4. Audit sampling (a) Define audit sampling and the relevance of sampling to the auditor. (b) Identify sampling selection methods, including random selection, systematic selection and haphazard selection. (c) State the main factors affecting sample sizes 5. Computer-assisted audit techniques (CAATs) (a) Explain the use of CAATs in an audit including the use of audit software and test data. (b) Explain the advantages and disadvantages of the use of CAATs to the auditor. 4. Recording significant and material errors (a) Explain the effect of identified misstatements on the audit. (b) Explain the effect of uncorrected misstatements on the financial statements. 5. Auditor s reports (a) Describe the form and content of unmodified auditor s reports (b) State the circumstances where an auditor shall issue a modified auditor s report. E AUDIT COMPLETION 1. Going concern (a) Define and discuss the significance of going concern. (b) Discuss indicators of going concern problems. (c) Explain the procedures to be applied in performing going concern reviews. 2. Subsequent events (a) Explain the responsibilities of the auditor regarding subsequent events occurring up the date of the auditor s report (b) Explain the procedures to be applied in performing subsequent event reviews. 3. Written representations (a) Explain the purpose of written representations. (b) Describe the circumstances where written representations are necessary. P.10 KAPLAN PUBLISHING

11 THE EXAMINATION Format of the examination Number of marks Section A Ten compulsory multiple choice questions 20 Section B 9 compulsory questions Q1 & 2 (15 marks each) 30 Q 3 & 4 (10 marks each) 20 Q 5 9 (6 marks each) 30 Total 100 Total time allowed: 2 hours Approach to examining the syllabus The examination is a two-hour written paper. Examination regulations issued or legislation passed on or before 31st August annually, will be examinable from 1st September of the following year to 31st August of the year after that. Examination tips Spend the first few minutes of the examination reading the questions. Unless you know exactly how to answer the question, spend some time planning your answer. Stick to the question and tailor your answer to what you are asked. Fully explain all your points but be concise. Set out all workings clearly and neatly, and state briefly what you are doing. Don t write out the question. If you do not understand what a question is asking, state your assumptions. Even if you do not answer precisely in the way the examiner hoped, you should be given some credit, if your assumptions are reasonable. If you get stuck with a question, leave space in your answer book and return to it later. KAPLAN PUBLISHING P.1 1

12 PAPER FAU : FOUNDATIONS IN AUDIT Answering the questions Essay questions: Make a quick plan in your answer book and under each main point list all the relevant facts you can think of. Then write out your answer developing each point fully. Your essay should have a clear structure; it should contain a brief introduction, a main section and a conclusion. Be concise. It is better to write a little about a lot of different points than a great deal about one or two points. Computations: It is essential to include all your workings in your answers. Many computational questions require the use of a standard format: company statement of profit or loss and other comprehensive income, statement of financial position and cash flow statement for example. Be sure you know these formats thoroughly before the examination and use the layouts that you see in the answers given in this book and in model answers. If you are asked to comment or make recommendations on a computation, you must do so. There are important marks to be gained here. Even if your computation contains mistakes, you may still gain marks if your reasoning is correct. Please note that it is unlikely that you will be required to prepare computations in FAU. Reports, memos and other documents: Some questions ask you to present your answer in the form of a report or a memo or other document. Use the correct format there could be easy marks to gain here. P.12 KAPLAN PUBLISHING

13 STUDY SKILLS AND REVISION GUIDANCE Preparing to study Set your objectives Before starting to study decide what you want to achieve the type of pass you wish to obtain. This will decide the level of commitment and time you need to dedicate to your studies. Devise a study plan Determine when you will study. Split these times into study sessions. Put the sessions onto a study plan making sure you cover the course, course assignments and revision. Stick to your plan! Effective study techniques Use the SQR3 method Survey the chapter look at the headings and read the introduction, summary and objectives. Get an overview of what the text deals with. Question during the survey, ask yourself the questions that you hope the chapter will answer for you. Read through the chapter thoroughly, answering the questions and meeting the objectives. Attempt the exercises and activities, and work through all the examples. Recall at the end of the chapter, try to recall the main ideas of the chapter without referring to the text. Do this a few minutes after the reading stage. Use the MURDER method Mood set the right mood. Understand issues covered and make note of any uncertain bits. Recall stop and put what you have learned into your own words. Digest go back and reconsider the information. Expand read relevant articles and newspapers. Review go over the material you covered to consolidate the knowledge. Review check that your recall notes are correct. KAPLAN PUBLISHING P.1 3

14 PAPER FAU : FOUNDATIONS IN AUDIT While studying Summarise the key points of the chapter. Make linear notes a list of headings, divided up with subheadings listing the key points. Use different colours to highlight key points and keep topic areas together. Try mind-maps put the main heading in the centre of the paper and encircle it. Then draw short lines radiating from this to the main sub-headings, which again have circles around them. Continue the process from the sub-headings to sub-sub-headings, etc. Revision The best approach to revision is to revise the course as you work through it. Also try to leave four to six weeks before the exam for final revision. Make sure you cover the whole syllabus. Pay special attention to those areas where your knowledge is weak. If you are stuck on a topic find somebody (a tutor or a colleague) to explain it to you. Read around the subject read good newspapers and professional journals, especially ACCA s Student Accountant this can give you an advantage in the exam. Read through the text and your notes again. Maybe put key revision points onto index cards to look at when you have a few minutes to spare. Practise exam standard questions under timed conditions. Attempt all the different styles of questions you may be asked to answer in your exam. Review any assignments you have completed and look at where you lost marks put more work into those areas where you were weak. Ensure you know the structure of the exam how many questions and of what type they are. P.14 KAPLAN PUBLISHING

15 Chapter 1 AUDITING AND THE AUDIT PROFESSION INTRODUCTION This chapter provides an introduction to the role and function of auditing and considers the structure and regulation of the auditing profession. This chapter covers syllabus areas A (1), A (5). CONTENTS 1 The nature of accounting records and audit 2 The purpose of the external audit 3 International Standards on Auditing 4 The relationship between auditing and accounting LEARNING OUTCOMES At the end of this chapter, you should be able to: explain the nature, purpose and structure of an audit understand the structure and role of the auditing profession appreciate the main mechanisms which currently regulate the auditing profession explain the role of both auditing and accounting standards. KAPLAN PUBLISHING 1

16 PAPER FAU : FOUNDATIONS IN AUDIT 1 THE NATURE OF ACCOUNTING RECORDS AND AUDIT 1.1 THE NATURE OF ACCOUNTING RECORDS Businesses, both sole traders and incorporated companies, need to satisfy the informational needs of a wide range of stakeholders. Examples of typical stakeholders and their informational requirements include: Shareholders they need information about company performance to aid investment decisions; Lenders/financial institutions they need information about the liquidity of a business to make lending decisions; Government institutions they need information to support the calculation and payment of relevant corporation and income taxes; Management they need information to support operational decisions and business strategy; Employees they need information relating to the liquidity and performance of a business to assess job security and remuneration potential; Customers/suppliers need information about the liquidity of a business to decide whether to commit to long term trading partnerships; The public they require a wide range of data; environmental and corporate social responsibility information is currently popular. Each stakeholder requires good quality information to assist their decisions, all of which are significant to the stakeholder in question. If the information they use is of poor quality then they are likely to make poor quality decisions. Therefore providing them with the correct quality of information is a significant undertaking. In order to meet these requirements company directors/management prepare a number of reports for use by the stakeholders identified above. They are too numerous to prepare a comprehensive list so a summary of some of the key documents is included below: Management accounts these are typically used internally by management and employees for internal, operational and financial decisions. They include budgets/targets, performance to date and management commentaries. These are occasionally provided to lenders, at the discretion of management, to support loan/finance applications. Taxation computations and returns these include summaries of sales and purchases to support sales tax and corporate tax payments and payroll reconciliations to support the payment of income taxes and social security payments. Financial statements these incorporate summaries of historical financial performance (statements of comprehensive income and cash flows) and summaries of year-end assets and liabilities (statement of financial position). These are usually required by law for most companies and are used primarily by shareholders, although they are available to the public. 2 KAPLAN PUBLISHING

17 AUDITING AND THE AUDIT PROFESSION : CHAPTER 1 Whilst there are different requirements for each piece of information produced there are two specific requirements of information reported in the financial statements that are significant; in accordance with the Conceptual Framework, information presented in the financial statements must: be relevant, meaning that the information must be capable of influencing the users decisions; and faithfully represent the transactions and balances it is reporting; meaning it must be complete, neutral and free from error. Financial information must also be understandable, produced on a timely basis, be comparable and be verifiable. It is vital that management have systems in place that support the preparation of this information. They must ensure that they set up appropriate systems, including accounting, and that they design appropriate controls to reduce the risk of fraud and error and to detect such problems if they do occur. Management must also establish systems sufficient to keep such records as long as they are required by stakeholders. For example; in the UK business records must be kept for a minimum of six years to satisfy tax regulations. 1.2 WHAT IS AN AUDIT? Whilst it is, of course, important to have a sound grasp of the meaning of the subject which you are studying you are not likely to be assessed directly on the definition of the word audit. It is therefore more important to grasp an appreciation of the ideas involved in the audit concept than to attempt to learn a definition word for word. One possible definition of an audit is: The independent examination of evidence from which the financial statements of an enterprise are derived in order to give the reader of those statements confidence as to the 'truth and fairness' of the state of affairs which they disclose. An alternative view is presented by ISA 200 the Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs: the objective of an audit is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. What can we see as the essential features of an audit from a combination of these definitions and explanation? An audit involves an examination of financial statements the auditor is not responsible for the preparation of financial statements. In the case of a limited company, it is the responsibility of the directors to prepare the financial statements the auditor then examines the financial statements and reports his opinion on the truth and fairness of the state of affairs disclosed. The end result of an audit is an opinion to assist the user of the financial statements auditing therefore relies heavily on professional judgement, not merely facts. The auditor s opinion makes reference to true and fair, or fair presentation but true and fair is again a matter of judgement it is not precisely defined for the auditor. KAPLAN PUBLISHING 3

18 PAPER FAU : FOUNDATIONS IN AUDIT In order for the user of the information to feel confident in relying on the audit report, the auditor should be independent of the enterprise subject to audit independent essentially means that the auditor has no significant personal interest in the enterprise. This allows an objective, professional view to be taken. You will note that this is a wide concept of an audit which can be applied to any enterprise, not just to limited companies. However we are concerned here primarily with the annual audits of the financial statements of limited companies (often known as statutory or external audits). Any other audit applications will be clearly indicated for you in the text. 1.3 EXAMPLE OF AN AUDIT REPORT It is appropriate to consider in brief the format and content of an audit report. This will be considered in more detail in subsequent chapters of this publication. You should note the following details within the specimen report as follows: (a) (b) (c) (d) (e) (f) (g) (h) a title identifying the person(s) to whom the report is addressed the auditors opinion on the financial statements the basis of the auditors' opinion key audit matters responsibilities of management responsibilities of the auditor the auditors signature and address the date of the audit report. INDEPENDENT AUDITOR S REPORT TO.[appropriate addressee] We have audited the accompanying financial statements of ABC Company, which comprise the statement of financial position as at December 31 20X1, and the statement of profit or loss and other comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory notes. Opinion In our opinion, the financial statements give a true and fair view of (or present fairly, in all material respects ) the financial position of ABC Company as of December 31 20X1, and of its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Basis for Opinion We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities under those standards are further described in the Auditor s Responsibility section of our report. We are independent of the Company in accordance with ethical requirements that are relevant to our audit, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for opinion. 4 KAPLAN PUBLISHING

19 AUDITING AND THE AUDIT PROFESSION : CHAPTER 1 Key Audit Matters Key audit matters are those matters that, in our professional judgement, were of most significance in the audit of the financial statements of the current period. These matters were addressed in the context of our audit of the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. [Description of each key audit matter in accordance with ISA 701] Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards. This responsibility includes: designing, implementing and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor s judgement, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. [Auditor s signature] [Date of the auditor s report] [Auditor s address] An unmodified audit report provides assurance (not a guarantee) that an independent examination of the accounts has not discovered any unadjusted material (i.e. significant) misstatements and that the financial statements give a true and fair view. You should note that it is also possible for the auditor to issue a modified audit report. This may occur when the auditor is either of the opinion that there is a material misstatement in the financial statements, or when the auditor has been unable to obtain sufficient appropriate evidence upon as a basis for the audit opinion. KAPLAN PUBLISHING 5

20 PAPER FAU : FOUNDATIONS IN AUDIT 1.4 THE DEVELOPMENT OF MODERN EXTERNAL AUDITING Modern auditing owes its origins to the development of a number of fiduciary relationships, the most important for our purposes being the relationship between company directors and shareholders. Definition A 'fiduciary' relationship is a relationship of 'trust and good faith' such as that between a trustee and a beneficiary, and between directors and shareholders. It was recognised many years ago that whenever a fiduciary relationship with financial implications existed think of the relationship between company directors and the shareholders in the company there was a need for an outsider (what we would now refer to as an independent auditor) to review the accounts reflecting financial transactions and to express an opinion as to their honesty (we would now say truth and fairness) or otherwise. These relationships in the context of companies can be shown as follows: Owners Managers Shareholders Directors and managers Provide finance Use finance Produce accounts for shareholders showing the results of their use of shareholders funds Auditors Examine accounts and report to members on their truth and fairness The relationship shown here is often described as depicting the divorce of ownership from control. The shareholders own the company, but a different group, the directors, manage and control the company on behalf of the shareholders. This is an application of the agency principle as the shareholders elect the directors to manage the company on their behalf. In effect, the directors have a responsibility of stewardship to account to the shareholders for the way they have managed the company. This is achieved by the directors preparing annual financial statements, which are audited, for presentation to the shareholders. 6 KAPLAN PUBLISHING

21 AUDITING AND THE AUDIT PROFESSION : CHAPTER 1 The auditor acts as an independent referee, reporting to the shareholders on the financial statements prepared by the directors. Company legislation in most countries now requires auditors to express an opinion on the truth and fairness of the statement of comprehensive income and the statement of financial position, both of which should be prepared by directors and presented to the shareholders. In addition, it is generally required that auditors should possess a recognised professional qualification and detailed provisions can be laid down regarding their duties, powers and responsibilities. 2 THE PURPOSE OF THE EXTERNAL AUDIT 2.1 INTRODUCTION As described above, the need for an external audit centres on the requirements of the users of the accounts who are primarily, but not solely, the shareholders in the case of company audits. There are also many other outside parties who use the financial statements as a basis for making decisions regarding a company. Bankers, suppliers and lenders as well as potential investors, customers and employees all have an interest in the state of the company's financial affairs. The independent audit requirement fulfils the need for a professional opinion on whether those financial statements are objective, free from bias and manipulation and relevant to the needs of the users. 2.2 ADVANTAGES OF AN AUDIT As we have seen, the need for an external audit in the case of companies arises primarily from the existence of divorce of ownership from control. There are however, certain advantages in having financial statements audited even where no statutory requirement exists for such an audit in the case of a sole trader, partnership, club or society for example. These advantages can be summarised as follows: (a) (b) (c) (d) Any audit will give assurance to readers of the accounts (e.g. current investors, potential investors, senior managers of the business) that the accounts have been properly drawn up and give a fair presentation of the financial position of the business. For example, the members of a sports club might choose to have the club s accounts audited each year, to give assurance to the members that their subscription paid had been used properly as set out in the published financial statements. Disputes between stakeholders may be more easily settled. For instance, a partnership which has complicated profit-sharing arrangements may require an independent examination of those accounts to ensure as far as possible an accurate assessment and division of those profits. Major changes in ownership may be facilitated if past accounts contain an independent audit report, for instance, where two sole traders merge their business to form a new partnership. Applications to third parties for finance may be strengthened by the submission of audited accounts, as it adds credibility to the figures. However, do remember that a bank, for instance, is likely to be far more concerned about the future of the business and available security, than by the past historical accounts, audited or otherwise. KAPLAN PUBLISHING 7

22 PAPER FAU : FOUNDATIONS IN AUDIT (e) The audit is likely to involve an in-depth examination of the business and so may enable the auditor to give constructive advice to management on improving the efficiency of the business. 2.3 DISADVANTAGES OF AN AUDIT Like most things in life, audits are not entirely without their disadvantages. There are two main points to make here: (a) (b) The audit fee! Clearly the services of an auditor must be paid for. It is for this reason that few partnerships and even fewer sole traders are likely to have their accounts audited. The audit involves the client's staff and management in giving time to providing information to the auditor. Professional auditors should therefore plan their audit carefully to minimise the disruption which their work will cause. It is also worth pointing out that audits are only really useful when there is a separation of ownership and control. However, in many cases the directors may also be the majority shareholders, even in relatively large companies. In these circumstances is there any need for the financial statements to be audited? ACTIVITY 1 A sole trader has just started a business and has asked you to explain whether his business will have to undergo a statutory audit and, if not, what benefits he may derive from having an audit performed on a voluntary basis. Outline the main points which you would make in reply to his enquiry. For a suggested answer, see the Answers section at the end of the book. 3 INTERNATIONAL STANDARDS ON AUDITING 3.1 INTRODUCTION The organisation and structure of the auditing profession will, of course, vary from country to country. Knowledge of how the profession operates in any given country is clearly beyond the scope of this paper. However, there is a clear movement towards harmonisation of both auditing and accounting standards throughout the world. All companies listed in the European Union have been required to use International Financial Reporting Standards (IFRSs) since January 2005 and the use of International Standards on Auditing (ISAs) has been a requirement in the EU since ACTIVITY 2 Carry out a short research project to identify the main bodies involved in the accountancy and auditing profession in your own country. There is no feedback to this activity. 8 KAPLAN PUBLISHING

23 3.2 THE AIMS AND ORIGINS OF ISAS AUDITING AND THE AUDIT PROFESSION : CHAPTER 1 International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB) which is based in New York. The IAASB functions as an independent standard setting body under the responsibility of the International Federation of Accountants (IFAC). The aim of the IAASB is to develop and issue high quality auditing standards to improve uniformity of practice by accountants throughout the world, thereby strengthening public confidence in the audit process globally. IAASB pronouncements are developed following a process that includes input and consideration by the general public, IFAC member bodies and their members, and a Consultative Advisory Group that represents regulators, preparers, and users of financial statements. The IAASB works closely with its members and national standard setters in order to gain acceptance of International Standards on Auditing (ISAs). It expects its members to have due regard for ISAs in setting national standards. Member bodies have increasingly sought to align the national position with the international position as IFAC and the IAASB have gained influence and recognition. Standard setters increasingly refer to the international position in their consultative documents as authoritative support for a particular view. International auditing and accounting standards do not at present override local regulations. Neither IFAC nor the IAASB can currently compel any organisation to comply with international standards; nor are there specific IFAC sanctions where organisations claim to have complied with international standards, but have not done so. However, this situation will change as more and more countries adopt international standards rather than imposing their own domestic standards. For example, all listed European companies have been required to adopt international accounting standards since 2005, and the UK and Ireland have required all audits to be carried out in compliance with ISAs since December IAASB pronouncements fall into a number of categories: IFAC Code of Ethics and Conduct for Professional Accountants International Standards on Quality Control (ISQCs) Audits of historical financial information Other engagements International Standards on Auditing (ISAs) Other documents International Auditing Practice Statements (IAPSs) The IFAC Code of Ethics and Conduct sets standards of conduct for professional accountants and states the fundamental principles that should be observed. KAPLAN PUBLISHING 9

24 PAPER FAU : FOUNDATIONS IN AUDIT International Standards on Quality Control (ISQCs) provide guidance to auditors in their responsibilities to maintain good quality control over their audit engagements. International Standards on Auditing (ISAs) provide guidance to auditors in carrying out their audit engagements. The basic principles and essential procedures (identified in each ISA in bold lettering) are mandatory guidance. Other guidance is only advisory in status. International Auditing Practice Statements (IAPSs) provide practical assistance to auditors in interpreting and implementing standards and promote good practice. They are not intended to have the authority of standards. 3.3 DEVELOPMENT OF INTERNATIONAL STANDARDS ON AUDITING The stages are similar to those in developing accounting standards: an Exposure Draft is issued with a request for comments by a specified date the comments are reviewed and, where appropriate, the draft amended the ISA is issued with a specified implementation date. 4 THE RELATIONSHIP BETWEEN AUDITING AND ACCOUNTING Auditing and accounting are closely connected but separate activities. The directors of a company are responsible for establishing records which will accurately record transactions and which are used for preparing the annual financial statements. It is similarly the responsibility of the directors to adopt consistent and appropriate accounting policies in order to prepare the financial statements. For the purposes of this exam, we assume that the financial statements have to comply with legislative requirements and International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs). The International Accounting Standards Board (IASB) assumed responsibility for setting these accounting standards from 1 April There is also a conceptual accounting framework in issue (the Framework) which sets out the concepts that underlie the preparation and presentation of the financial statements for users. Auditors are primarily concerned with the end result of this work i.e. do the financial statements show a 'true and fair' view? In order to arrive at their conclusion the auditors must have a deep knowledge and understanding of accounting (including applicable accounting standards) and, in practice, the directors will consult with the auditors as to appropriate accounting policies to follow. CONCLUSION This chapter gives you a basis for studying the detail of audit regulation and procedures which are dealt with in later chapters. As a result of studying the contents of this chapter you should have gained a general understanding of the role and structure of an audit. You should note that most of what follows is dealing with the statutory (external) audit. The overriding objective of this is for an independent professional accountant to establish and be able to report whether the financial statements present a true and fair view. 10 KAPLAN PUBLISHING

25 AUDITING AND THE AUDIT PROFESSION : CHAPTER 1 KEY TERMS Audit The independent examination of evidence from which the financial statements of an enterprise are derived in order to give the reader of those statements confidence as to the 'truth and fairness' of the state of affairs which they disclose. Fiduciary relationship A relationship of 'trust and good faith' such as that between a trustee and a beneficiary, and between directors and shareholders. International Standards on Auditing (ISAs) Statements containing basic principles and essential procedures for the auditor to follow together with related guidance in the form of explanatory and other material. International Financial Reporting Standards (IFRSs) Pronouncements issued by the International Accounting Standards Board providing guidance in respect of the treatment and disclosure of accounting items in the financial statements. Recognised Supervisory Body (RSB) a body that exists to ensure that its members comply with its rules, thereby ensuring that all audits are performed to a satisfactory standard by qualified persons. Financial Reporting Council (FRC) the unified independent regulator of the accounting and auditing professions which is responsible for setting accounting and auditing standards, pro-actively enforcing and monitoring them and overseeing the self-regulatory professional bodies through its five subsidiary boards. SELF TEST QUESTIONS Paragraph 1 What is an audit? What does the concept of divorce of ownership from control mean? What are the main advantages of the typical external audit? What is the IAASB? Distinguish between an ISA and an IAPS. 3.2 PRACTICE QUESTION 1 KID BROTHER Your younger brother has written to you stating that he is contemplating following your footsteps into the accountancy and auditing profession. However, he is finding difficulty in understanding the nature and purposes of an audit and he has asked for your assistance. Write an appropriate letter, in language that a layperson can understand, describing an audit, with particular emphasis on its nature and purposes. (Use fictitious names and addresses. Marks will be awarded specifically for style as well as for content.) (Total: 20 marks) For a suggested answer, see the Answers section at the end of the book. KAPLAN PUBLISHING 11

26 PAPER FAU : FOUNDATIONS IN AUDIT PRACTICE QUESTION 2 (a) Give a definition of an audit, and explain the significance of the terms therein. (10 marks) (b) What is the role of the IAASB? (5 marks) (Total: 15 marks) For a suggested answer, see the Answers section at the end of the book. 12 KAPLAN PUBLISHING